Since the Chancellor’s Autumn Budget announcement on plans for pensions to be integrated into inheritance tax (IHT) calculations from 2027 onwards, many individuals have come to me looking for mitigation tips.
While there are a number of options when it comes to mitigating IHT on pensions, one suggestion is to use your funds to buy an annuity. While this will work for some, there are a good number of considerations to take into account when thinking about this option.
Taking funds out of your estate by way of an annuity
While it is safe to say that buying an annuity will reduce the size of your estate in the new world of IHT and pensions, the exact reduction amount depends on the type of annuity purchased – the more bells and whistles you add, the greater the cost.
However, if the plan for your pension before the changes were announced was to leave the funds untouched to pass on, it’s important to note that taking it out of the estate will reduce the amount left behind.
While some may want to explore buying an annuity with a spouse’s pension, this isn’t really an attractive solution, given passing assets to a spouse is tax-free anyway. Meanwhile, for those considering buying annuity protection, it is important to consider that in the event a protection payment is made, this will come back into the estate on death.
One option is to buy an ongoing income annuity for someone other than the spouse, but this would be very costly for a younger person if you can even secure a quote.
Taking the funds out of your estate by way of an annuity does of course give you guaranteed income, but it is important to remember that this income can’t be ignored. It flows back into your estate immediately, meaning that should it be in excess of requirements, it will incur income tax, and possibly eventually be subject to IHT as well, just changing the order of double taxation.
You can’t just stop and start annuity income either, which means should there any other future changes in legislation, you will also be subject to these too. We have seen this in the past where there seemed to be ways around things, but then legislation changed, meaning individuals would have had a better outcome had they maintained flexibility.
The right way to go?
Leaving funds within drawdown and using tax free cash payments to reduce the estate initially, if possible, before using an appropriate decumulation strategy still feels like the best route for those with larger funds. You can still benefit from growth, minimise unnecessary taxation and plan according to any changes that may still creep in.
I am by no means saying that annuities don’t have place, but they need careful consideration and to be used for the right reasons. There are plenty of things to consider with retirement income planning, and now more than ever should we be looking at the all-asset model to use all available allowances to get the best outcome for our clients.
As with all things, this is a very personal decision, complicated further by the general complexities of the interaction of pensions and IHT legislation. It all leads to the need for holistic personalised financial advice that factors in everything a client holds as well as their thoughts, feelings and needs.
We are all different. One client will be driven by maximising income in life and hence reducing income tax, others may be all about maximising what can be left to others when they are gone. By providing holistic financial advice, we can help clients make an informed decision aligned with the individual needs of both themselves and their families.
Claire Trott is divisional director of retirement and holistic planning at St James’s Place
Hear, hear. Before all this pension freedom nonsense there wasn’t even a debate. If clients ony asset is their pension I would contend they were poorly advised. It was never envisaged that a pension was a potential handed down asset. It was there to provide a secure and guranteed income and at the same time the asset falls outside the estate – a win win. As well as all the other attributes – joint and impaired lives, the option of escallation and the knowledge that the widow/widower won’t need to keep paying an adviser.